June 2009

Even though the concept of asset/liability management for banks has been around for 40+ years, there’s still relatively few books out there that cover the topic. There’s even fewer that cover it without overwhelming you with technical jargon.

A better title for the book would be “Interest Rate Risk Basics…” because much of the book focuses on IRR, with less focus on Capital, Asset Quality, and Liquidity risk. That shouldn’t keep you away though.

While the text does throw around the industry buzzwords, it doesn’t make the book unreadable. The author uses somewhat of a no-nonsense style which should keep you from becoming a deer-in-the-headlights.

I highly recommend the book for anyone looking for a reasonably short, understandable guide to A/L management and interest rate risk.

I posted something similar to this about two months ago. I just ran across something today that I think further illustrates the point. If you haven’t already visited the site Indexed, I suggest you take a look. She posts some pretty clever stuff. I adapted one of her latest posts to better illustrate my view that when it comes to A/L modeling, there’s usually too much data and not enough understanding.

Point A – lots of understanding, little supporting data Perhaps label this point “Experience”. Many community bankers are here. They have a great deal of experience in their local market, and a solid understanding of their balance sheet structure. It represents that intuitive knowledge that most community bankers have. What they lack is a good tool that correctly reports their position and risk profile. (A multi-page Excel workbook doesn’t cut it)

Point B – lots of data, little understandingA more descriptive way of labeling this point would be “thud factor”. I first heard the term from an independent investment advisor we deal with. That’s how he described the bond accounting reports that most brokers send to community bankers. “They bury them with data,” he would say. I think this is true of many A/L models as well. Especially in-house models or modules hung off the bank’s loan or G/L system. There’s usually an endless stream of reports. Most community bankers yank out one page from a pile like this and put the rest in the circular file.

Point C – Where you want to beThe right mix of experience and information to support your position. Obviously I’m inclined to think that our A/L BENCHMARKS customers are here. Certainly the feedback from our clients is that our Board Report is an excellent tool. It helps match the appropriate data to experience and understanding which ultimately makes communication with senior management and regulators much easier.

If you’re a good planner, prudent, and/or forward-thinking (or maybe just lucky) you’ll travel from point A to point C. The journey from point B to point C is like climbing out of a very deep well. Sifting through mind-numbing stacks of reports is going to take a while, and it’s also apt to be quite frustrating. How do you even know you have the “right” data to start with?

Occasionally, although more frequently than I’d like, we run into problems mapping the data from a bank’s call report into A/L BENCHMARKS. Usually the problems stem from the fact that some important data points are just plain missing from the call report, and we have to estimate them. The biggest culprit is Schedule RC-K, average balances. There is a whole host of “missing” averages, especially if you consider how many detail end-of-period balances the call report does have.

Problems also crop up when the FFIEC decides to change or reclassify balances from one category to another – for instance, the line item that’s the subject of this post, “Equity Securities that do not have readily determinable fair values”. These are securities like Fed Reserve Stock, FHLB Stock, and basically anything that falls outside the scope of FASB Statement No. 115.

Prior to March 31, 2001 the call report included these securities on Schedule RC-B – Securities. After that, they were moved to Schedule RC-F – Other Assets. I know, who cares, right? The problem is this: these securities are now no longer reported as part of earning assets, they’re now “other assets”. But they still can produce income. And when they do produce income it is reported as interest & dividend income (and therefore included as part of interest margin). In other words – you’re now potentially overstating yield.

You compute yield by dividing income by the average balance that generated that income. If you remove the average balance for these securities, the yield is potentially overstated. It’s now wrong.

I had a discussion with an examiner about this and his response was that these securities aren’t saleable and they’re not currently producing income. I agree with both facts. However I do not think they are good reasons for moving these securities to other assets.

1) “these securities aren’t saleable” – In the context of our conversation he was really referring to our current economic environment. Yes, the markets stink right now. But if that’s the criteria then given our current financial climate there are a lot of assets that aren’t currently saleable. A better comment would have been that there are specific regulatory and accounting restrictions on selling these assets, which is true. But that doesn’t keep them from potentially producing income. Which leads me to the second point…

2) “these securities aren’t currently producing income” – This is a really bad argument. So what? Again in this climate there may be more than a few earning assets that aren’t producing income at the moment. That doesn’t mean they should be “declassified” as an earning asset. Imagine how great my loan yields would look if I could simply reclassify my non-performers as “other assets”. Think of the risk-based-capital benefits alone! ;)

The FFIEC is well aware that these assets can produce income, as they’ve given them a separate specific line item on Schedule RI, line 1.g:

So what do we do when they start producing income again…reclassify them back as earning assets?

This call report error causes the reported yield on earning assets to be overstated. Granted the error is usually small because the balances in this category are not generally huge compared to total assets. But why introduce the error in the first place?

There’s an excellent post today on the Bank Lawyer’s Blog. He’s the only attorney I enjoy listening too. I actually look forward to his posts. He writes from the refreshing perspective of the small community bank. Today’s post talks about fair value accounting. Here’s the excerpt I find particularly interesting:

One of my mentors…used to wonder how people who were mark-to-market devotees lived on a day-to-day basis. Why didn't they simply spiral down into terminal depression each day the market dropped and rocket up into an orgasmic ecstasy each day the market rose? I mean, if mark-to-market is reality, then reality can bite or be pure bliss, and all in the same day, can't it? Is that how we want to live? Is that how we want invest and plan for the long term?

I couldn’t agree more. (For a lawyer I think he was remarkably succinct!) I’m fascinated by this marked-to-market/fair value movement that drags everything onto the income statement – only to have people (read politicians & press) demand better risk management to control “all this volatility”. It’s the market stupid - don’t investment and portfolio managers tell us all the time to look past the short-term fluctuations and see the bigger picture?

I love one of the final thoughts in the post:

I'm not against FASB or mark-to-market principles as a general proposition. I'm simply against falling in love with any accounting concept or principle and treating it like it's sacrosanct no matter what the circumstances and no matter what the effect. That's called "fanaticism."

At the risk of being too snarky, I’ll avoid answering this by saying, “Because the UBPR and regulators calculate it wrong”, and instead illustrate the difference and let you decide.

Just so we’re clear, the Non-Core Funding Dependency Ratio (NCFD) is a typical measure of contingency liquidity. This ratio measures the relationship between long-term earning assets and net short-term funds. Long-term earning assets are securities which mature beyond one year and all loans. Net short-term funds are large CDs, brokered deposits less than $100K, foreign deposits, fed funds purchased, repos, and other borrowings maturing within one-year, net of short-term investments. A rule of thumb is that the lower the NCFD ratio the better. When the bank's short-term investments exceed its short-term borrowings this ratio will be negative and is usually considered a good thing since it reflects a greater capacity to acquire additional assets and liabilities. This snapshot ratio exposes the reliance on "non-core" sources to fund the bank's long-term asset base.

Let’s take a look at two different NCFD calculations for a sample bank (click on the image to see it full size):

The only difference between the two is the “Total Securities” amount which results in the two different NCFD ratios 53.00% versus 52.75%. So, why does A/L BENCHMARKS use a different total securities amount? Because we still include “Equity securities that do not have readily determinable fair values” as part of total securities, the call report does not. The call report used to…prior to March 31, 2001. I’m not sure why it’s now included as an “other asset” because it still can produce income which is included as part of margin. If its income is part of margin, the balance should be reported as an earning asset, not as an other asset. Otherwise you’re going to overstate the bank’s yield.

So, yes A/L BENCHMARKS reports NCFD differently. In this case the difference is 0.25%, that’s one-quarter of one percent (in almost all cases the difference is this small)…is it enough of a difference to worry about? I don’t think so.